What's a Treasury Secretary to Do? An Agenda for Henry Paulson, Here and Abroad

One issue that Henry Paulson will be unable to avoid as secretary of the Treasury is the precarious international financial position of the United States. Two of his most famous predecessors, John Connally in 1971 and James Baker in 1985, faced very similar situations when they assumed office midway through the terms of their Republican presidents. Both launched dramatic initiatives that resolved the problems and became their signature accomplishments. The central strategic question facing Paulson is whether he will likewise seize control and take effective preemptive action or will instead try to skate through without policy changes and thus run an enormous risk of severely jeopardizing the US and world economies.

The United States has to attract about $8 billion of foreign capital every working day to finance its current account deficit—which has risen steadily for 15 years and is approaching $1 trillion annually—as well as its own foreign investments. Any substantial reduction of that inflow, let alone a conversion into other currencies of the $12 trillion now floating around the world, could send the dollar into a tailspin. Inflation could double, to at least 5 or 6 percent. Interest rates would rise sharply and could hit double digits. Equity and housing markets would tank. The economy would fall into recession, and unemployment would rise sharply. These effects would be magnified if energy prices rose further, recalling the stagflation of the 1970s and risking a "hard landing" for the US and world economies.

Moreover, large and rising current account deficits based on substantial overvaluation of the dollar have always been precursors of protectionist US trade policies. We are witnessing just such pressures today, especially against China, despite the rapid expansion and full employment of the US economy. The emotional congressional rejections of a harmless "Chinese takeover" of a US oil company and an equally harmless "Arab takeover" of a few US port operations could be harbingers of financial as well as trade protectionism. It's not pretty to contemplate US trade policy, and hence the global trading system, in a year or two if US growth slows sharply and joblessness rises while our global trade deficit exceeds $1 trillion and the bilateral imbalance with China rises to $300 billion to $400 billion. The fact is that the US external deficits are unsustainable, and they would be even if the rest of the world were willing to finance us indefinitely.

Incoming secretaries Connally and Baker confronted similar situations and policy choices. The United States was facing record external deficits. Foreigners were becoming skittish about continuing to provide the needed financing. Congress was seriously contemplating major protectionist legislation. Japan was widely viewed as a threat to US prosperity, as is China today.

Both Connally and Baker rejected the temptation to try to skate through. They decided to adopt bold new policies, reversing the "benign neglect" of the earlier years of their administrations, to regain control of the issue both internationally and domestically vis-à-vis Congress. In 1971 Connally and President Richard Nixon took the dollar off the gold standard and applied a 15 (later 10) percent surcharge on all imports to force two negotiated devaluations totaling more than 20 percent. In 1985 Baker won cooperation from the Group of Five that drove the floating dollar down 30 percent over the next two years. Both strategies worked: US exports soared, the external position moved into surplus at least temporarily, world growth continued and "hard landings" were largely avoided. And congressional trade pressures were blunted.

The situation inherited by Henry Paulson is both better and worse than that facing his predecessors. On the favorable side, US productivity growth underpins a much stronger domestic economy. The inflation-fighting credibility of the Federal Reserve is far better established. The lassitude of the other industrial countries strengthens the relative investment attractiveness of the United States. Thus a "hard landing"—while quite possible if some unexpected shock should jar market confidence in US economic performance or policy—is not the most likely outcome. Many of Paulson's new colleagues and advisers will urge him to "stay the course."

On the negative side of the ledger, however, the current account deficit is more than double its previous highs. Instead of being the world's largest creditor country, as it still was in the 1980s, the United States has become by far the world's largest debtor. The creation of the euro means that, for the first time in its century of global financial dominance, the dollar faces a real competitor that reduces the prospect of foreigners funding our deficits simply because "there's no place else to put the money." The bilateral imbalance with China is twice as great as any imbalance ever reached with Japan, underlining the risks of new trade barriers. Continued inattention to the problem would produce larger and larger imbalances that would heighten even further the international financial and trade policy risks, which could erupt at any time.

The best outcome would thus be a gradual fall in the exchange rate of the dollar by another 20 to 30 percent over the next few years. Its latest long-term decline in fact began in 2002, after almost seven years of appreciation, and is a necessary component of a constructive international package that would cut the US external deficit roughly in half and thus have a chance of restoring its sustainability without severe damage along the way. That adjustment also requires a slowdown in the growth of US domestic demand to curb our excessive appetite for foreign goods and foreign capital—preferably through tighter fiscal policy but at least partially through higher interest rates. The third element is an acceleration of domestic demand in Asia and Europe to offset the reductions in their trade surpluses that will correspond to lower US deficits, without which their growth and world growth will slow sharply. There is a good prospect of correcting the imbalances without a recession or escalation of trade restrictions under this "soft landing" scenario.

Paulson thus confronts a strong case for acting promptly and decisively to handle the inevitable adjustment in the least disruptive manner. The United States must lead with a credible program to restore the modest budget surpluses of five years ago, perhaps by reinstituting the tough "pay-go" spending procedures of the 1990s in Congress, backed by presidential vetoes of excess appropriations, and enhancing revenue through full taxation of Social Security payments and letting some of the recent tax cuts expire as scheduled. China, now that its leadership openly acknowledges that the economy is again overheating and must be restrained, can substantially revalue its currency to deal with internal as well as external needs. This would permit other Asians to let their exchange rates rise significantly without losing competitive position to China. Under this scenario, as the euro rises against the dollar (though probably not against the Asian currencies) and reduces European inflation, the European Central Bank should be able to ease monetary policy to stimulate domestic demand in the world's second-largest economy.

The actual corrections will take several years to work through, but a credible commencement, including "down payments"—by the United States on budget tightening and by Asia on currency revaluation—would reassure markets and temper the political backlash. Fortunately, the process can start via the International Monetary Fund, which has already obtained agreement for consultations on it among the five key players (the United States, Europe, Japan, China, and Saudi Arabia for OPEC)—though it might ultimately require something like the famous Smithsonian Agreement under Connally or the Plaza Agreement achieved by Baker. Paulson's decisions on these issues will go far toward determining his own legacy and whether the Bush administration can restore some of its diminished authority and credibility by effectively defending the global economic interests of the United States.